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Investing in China’s banking system requires act of faith

BANKERS and lawyers who operate in Beijing came down to earth with a thump last week. For months, they were the kings of town as they bunkered down to prepare the record $US21.9 billion ($28.46 billion) listing of Industrial & Commercial Bank of China.
With the job done (for shared fees of $US400 million), the advisers find themselves lower down the pecking order: behind important visitors such as African heads of state, 48 of whom arrived for the weekend’s China-Africa “summit”.

To allow African delegations easy movement, Beijing’s authorities closed major roads and much else, creating traffic that has trapped bankers (and yours truly) in jams across the city. While the importance of advisers may have dropped, the share prices of Chinese banks continue to defy gravity.

The stock prices of ICBC, Bank of China, China Construction Bank and China Merchants Bank have all risen handsomely since floating, as shareholders gamble that lenders have reformed and will benefit from continuing double-digit economic growth. But how long before investor optimism falls?

China’s largest banks have listed in near-perfect conditions, against a backdrop of record global liquidity. On the mainland, corporate profits are high, inflation is tame and economic growth is stable. In spite of the reforms, banks face little real competition and enjoy juicy spreads between deposit and lending rates.

It was only two years ago that bad loans at ICBC represented 21 per cent of the portfolio. Only gigantic re-capitalisations and loan write-offs by the state have enabled the large banks to become solvent.

Imagine the scale. ICBC runs 18,000 branches nationwide, some with managers friendly to the capital requirements of local industrialists. Investors are betting that banks’ internal risk management culture and systems have, overnight, become sophisticated enough to stop poor lending or downright fraud.

In the words of Hong Kong governance activist David Webb, China has taken out the bad loans but has it taken out the bad lenders? Investors got a reminder of the not-too-distant past yesterday when it was announced that the former head of China Construction Bank had been given 15 years’ jail for taking $US500,000 in bribes to arrange loans.

Zhang Enzhao abruptly quit in June 2005, four months before CCB became the first of China’s big state-owned lenders to list in Hong Kong.

In short, it is remarkable that China’s biggest banks have raised tens of billions of dollars from international and domestic investors, given that their recent trading history has been so abysmal and the banking sector is so immature.

The banking system remains deficient in several key respects, such as proven risk management. The banks have entered a new world, where they also have to tackle market risks such as foreign exchange and interest rate volatility.

China’s legal environment is not mature enough, with huge improvements required in areas such as classification of property rights. The country has no independent ombudsman to adjudicate on consumer banking disputes.

Corporate governance within banks is largely untested, despite their efforts to hire independent non-executive directors.

While the banks have indeed been listed, the state retains about 80 per cent of the stock in each company. Will the state be a passive or active investor?

The Government wants banks to cool lending to prevent over-investment. But what if the banks have a commercial desire to create shareholder value by expanding lending?

Inside each bank is a Communist Party-controlled committee whose role is largely opaque. Banking executives claim that the chief role of the committees is to help enforce “discipline” among staff. Investors will have to take their word for it.

There is also a need to improve training, attract fresh talent and introduce performance targets and incentive schemes.

There is little doubt that the banks have made huge improvements compared with just two years ago. They have not felt ashamed to summon outside help, be it from McKinsey or foreign strategic partners such as Bank of America and Royal Bank of Scotland.

However, investors are either ignoring the risks in the rush for a fast buck or calculating that they can sell at the first sign of a slowdown.

Hong Kong-based Jing Ulrich, JP Morgan’s star China equity-watcher, remains bullish on Chinese banks – in the short term. She says cash-rich global investors remain desperate to increase their China exposure.

But she also says many fund managers are judged on a quarterly basis and so could hardly miss out on the likes of ICBC. Quite.

Sound monetary policy remains key

China will continue to pursue a sound monetary policy, which will be more closely linked to its industry, taxation and foreign exchange policies, a top central bank official said Thursday.”

In order to maintain stable and healthy national economic growth, we will continue to stick to a sound monetary policy,” Su Ning, deputy governor of the People’s Bank of China, said yesterday.

“And we will seek more and effective co-ordination with industry, taxation and foreign exchange policies when drafting our monetary policies,” the deputy central bank governor said, without elaborating.

The central bank would continue, as it did before, to employ a host of measures to curb expansive money supply and credit growth.

The measures may include open market operations, as well as interest rate and bank reserve ratio adjustment, Su told the BusinessWeek CEO Forum in Beijing.

The central bank has so far raised the interest rate twice and bank reserve ratio deposits that commercial banks are required to make with the central bank once this year in a bid to cool the sizzling economy.

Su said that macroeconomic tightening measures had already succeeded in reining in red-hot economic growth.

The Chinese economy grew 10.9 per cent in the first half of this year, with this growth slowing to 10.4 per cent in the third quarter.

But the economy still faces several challenges if it is to maintain robust yet healthy growth, Su said, pointing to slumping consumption, the soaring trade surplus and escalating fixed-assets investment.

The overall proportion of consumer spending in the national economy has been on a downward spiral for some time, which may pose problems for economic development, Su told the forum.

The proportion, Su said, has slid from 62 per cent in the 1980s to 52 per cent last year.

Problems related to the international balance of payments remain serious, with the foreign trade surplus continuing to soar this year, he said.

And the risk still remains that fixed-assets investment, which is “still bigger than it should be,” may rebound again, as local governments and enterprises continue to invest more money in projects, the deputy central bank governor said.

China’s fixed-assets investment grew by a spectacular 29.8 per cent in the first half of this year and increased 27.3 per cent in the first nine months of 2006.

The central bank, Su said, will put expanding domestic consumption high on its policy agenda.

The bank will also work to improve the credit structure, Su said.